This is an “unloved” rally. Expect a bumpy transition to a normal environment says JP Morgan’s Stephanie Flanders

9th July 2014

The market rally in the first half of 2014 is “unloved” says Stephanie Flanders, chief market strategist, UK and Europe at J.P. Morgan Asset Management because investors know the days of cheap money and exceptionally low market volatility cannot last forever.”Investors are looking for things to worry about in the second half of the year, and geopolitics and US monetary policy are likely to provide them. But even with the prospect of short-term turbulence, we think the environment still justifies a modest preference for riskier assets,” she says.

The fund manager has also published a Guide to the Markets with a series of charts covering all manner of economic indicators from deficits to growth rates and employment for the UK and the world.

The note also points out that fixed income markets have performed surprisingly well in 2014, in large part due to supply and demand dynamics in the market for long-term government bonds, especially US Treasuries. Higher long-term demand for these “safe” assets is likely to prevent long-term yields from returning to traditional levels for some time, but core fixed income markets are likely to come under some pressure in the second half of the year as the uncertainties hanging over the US recovery are lifted.

“There are structural forces which are likely to keep long-term interest rates lower, for longer. But we don’t think the exceptionally low rate expectations now built into US futures markets are consistent with even the most mediocre US economic recovery,” says Flanders. “It would not take much more evidence of faster growth and rising inflation in the US for investors to revise those expectations quite significantly. We think that could happen sooner than many now expect.”

With investors already bringing forward their expectations for higher rates in the UK, Flanders says the stage is set for a clear divergence in policy between the Anglo-American markets and continental Europe, where the European Central Bank has re-committed to “doing all that it takes” to confront the risk of deflation. This could see more money flowing into both core and periphery bond markets, and rates fall even lower.

“We are likely to see some bumpy times in fixed income markets but, as usual, investors can protect themselves by taking a diversified, flexible approach to the fixed income part of the portfolio. After so many years of cheap money and ample liquidity, neither bonds nor equities look cheap. But an improving economy still points to a modest overweight in equities, which can continue to do well even in a rising rate environment.”

The following chart highlights the historical correlation between stock prices and moves in interest rates. It challenges the conventional wisdom that rising interest rates are bad for stocks, showing that markets can do quite well if rates are rising from very low levels.

The firm says it also expects positive European earnings growth to materialise.

The past few months’ economic data have shown a loss of momentum in parts of Europe, most notably France. But with four consecutive quarters of positive real GDP growth the recovery is still moving forward and consumer confidence is continuing to rise. JP Morgan says it would expect this to translate into continued – albeit rather modest – growth into 2015, particularly if the completion of the ECB’s review of the state of European bank balance sheets and other recent policy measures improve the flow of credit to small and medium-sized companies.”

Andrew Goldberg, Global Market Strategist, J.P. Morgan Asset Management adds: “Profit margins are on the rise and could be another important driver of European corporate earnings. Nominal growth has been dampened, particularly in the periphery, by inflation trending lower. Export-oriented European companies have suffered from the emerging markets slowdown and the stronger Euro, but both of these drags are starting to moderate. If companies are able to control costs as nominal growth picks up, profit margins should rise, though this is clearly going to take longer than many had hoped.

“Europe’s recovery remains uneven and credit conditions remain a challenge. But gradually improving economic data and changes in consumer behaviour do set the stage for a shift in earnings momentum. The ECB has also reaffirmed its commitment to recovery, and this action has been welcomed by markets.”

This chart below shows that macroeconomic improvement and leading indicators like the PMI could be a forward indicator of positive earnings growth.